First-lien lenders to bankrupt chemical producer Momentive Performance Materials are racing to overturn a stunning decision that allowed the company to reset interest rates on more than US$1bn in secured debt.

The company successfully used a 2004 US Supreme Court decision from a personal bankruptcy case to reset the rate on its debts using a formula for determining the rate that adds as little as 100bp to the prime risk-free rate.

New York bankruptcy Judge Robert Drain ruled that the use of the formula was appropriate in the Chapter 11 bankruptcy context. He approved the company’s reorganisation plan last Thursday. The lenders are preparing their appeal already.

If the decision holds, lenders have argued that it could have a chilling impact on lending to all non-investment grade companies and could even impact lending to investment grade companies.

Banks and first-lien lenders have been willing to lend to troubled companies below investment grade because they had an expectation about how that debt would be treated even in bankruptcy, said Mark Bane, partner with law firm Ropes & Gray. Bane represents secured lenders in Momentive.

“The creditor who was previously prepared to lend at a certain rate will not do it,” Bane said. With Drain’s ruling, any company can file for Chapter 11 seeking a below market rate.

Bane argues that the significant increase in out-of-court restructuring during the last five years would not have happened if lenders had believed their rates could be easily reset in bankruptcy.

Comfort level

“The only way you could get out-of-court restructurings done is if the lenders are comfortable that whatever deal they reach will remain in place,” Bane said.

Now, secured creditors in a workout agreeing to a new secured loan at a certain interest rate have a problem, he argued. The company could reach an agreement with lenders, file for bankruptcy protection and unilaterally change the rate, he said.

Judge Drain’s decision was based on his reading of the Supreme Court case, Till v SCS Credit Corp, that suggested lenders are not entitled to make a profit on the new debt.

Bane and others argue the judge misunderstood the Supreme Court’s ruling. The profit the court was targeting, in the context of the subprime lender – SCS – in a consumer bankruptcy, cannot be applied to a commercial case when debt is negotiated by sophisticated parties, Bane argued.

Even if Judge Drain’s decision stands, it may not be catastrophic for lenders.

“If you are a secured creditor you would have preferred to not have this ruling,” said Thomas Slome, chair of the bankruptcy department at law firm Meyer, Suozzi, English & Klein.

“It will play into negotiations but it will not necessarily make it easy for debtors to get their way in renegotiating interest rates,” Slome said. “Because a secured lender would never agree that Judge Drain’s ruling was correct,” he said.

“It’s an arrow in the debtor quiver,” said Debra Dandeneau, a partner at another law firm Weil, Gotshal & Manges. But she added that the negotiations on interest rates is also just one of a myriad of negotiations between debtors and creditors.

Lenders are also hoping that the ruling will have little traction outside of Judge Drain’s courtroom. No other judge is bound by the Drain opinion, not even those in New York.